TheOriginsandSeverityofthe PublicPensionCrisis

DeanBaker
February2011

CenterforEconomicandPolicyResearch 1611ConnecticutAvenue,NW,Suite400 Washington,D.C.20009 2022935380 www.cepr.net

CEPR

The Origins and Severity of the Public Pension Crisis

Contents
Executive Summary ...........................................................................................................................................1 Introduction........................................................................................................................................................2 The Impact of the Economic Crisis on Pension Fund Assets....................................................................2 Projecting Future Pension Returns .................................................................................................................4 The Size of the Public Pension Shortfall in Context ..................................................................................10 Conclusion ........................................................................................................................................................15 References .........................................................................................................................................................16

About the Author

Dean Baker is an economist and Co-Director of the Center for Economic and Policy Research, in Washington, D.C.

Acknowledgments
Alan Barber, Hye Jin Rho, Kris Warner, and Nicole Woo gave helpful comments on earlier drafts of this paper.

CEPR

The Origins and Severity of the Public Pension Crisis

ExecutiveSummary
There has been considerable attention given in recent months to the shortfalls faced by state and local pension funds. Using the current methodology of assessing pension obligations, the shortfalls sum to nearly $1 trillion. Some analysts have argued that by using what they consider to be a more accurate methodology, the shortfalls could be more than three times this size. Based on these projections, many political figures have argued the need to drastically reduce the generosity of public sector pensions, and possibly to default on pension obligations already incurred. This paper shows: Most of the pension shortfall using the current methodology is attributable to the plunge in the stock market in the years 2007-2009. If pension funds had earned returns just equal to the interest rate on 30-year Treasury bonds in the three years since 2007, their assets would be more than $850 billion greater than they are today. This is by far the major cause of pension funding shortfalls. While there are certainly cases of pensions that had been underfunded even before the market plunge, prior years of under-funding is not the main reason that pensions face difficulties now. Another $80 billion of the shortfall is the result of the fact that states have cutback their contributions as a result of the downturn. The argument that pension funds should only assume a risk-free rate of return in assessing pension fund adequacy ignores the distinction between governmental units, which need be little concerned over the timing of market fluctuations, and individual investors, who must be very sensitive to market timing. This argument also fails to recognize the fact that over a long period, future stock returns are inversely related to current price-to-earnings (PE) ratios. If the current PE ratio is relatively low, as is now the case, then the assumption that the market will provide below average returns implies a further decline in the PE ratio, given the generally accepted growth projections for the economy. As a practical matter, the stock market has provided an average real return of more than 8 percent for 30-year periods when the PE ratio at the start was under 15 to 1. It is worth noting that if pension funds stop investing in equities, as some have advocated, this would imply higher taxes and/or lower benefits for public employees. It would also mean that other investors could expect to see higher future returns on their stock holdings. The size of the projected state and local government shortfalls measured as a share of future gross state products appear manageable. The total shortfall for the pension funds is less than 0.2 percent of projected gross state product over the next 30 years for most states. Even in the cases of the states with the largest shortfalls, the gap is less than 0.5 percent of projected state product. It is also worth noting that some of this shortfall has likely already disappeared as a result of the recent rise in the stock market. If this rise is not subsequently reversed, then a substantial portion of the funding shortfall has already been eliminated.

CEPR

The Origins and Severity of the Public Pension Crisis

In sum, most states face pension shortfalls that are manageable, especially if the stock market does not face another sudden reversal. The major reason that shortfalls exist at all was the downturn in the stock market following the collapse of the housing bubble, not inadequate contributions to pension funds.

Introduction
In recent months, there has been a considerable effort by many political actors to promote fears over the size of public pension shortfalls. While many, if not most, public pensions do face shortfalls, much of the discussion has been misleading about both the origins of the shortfall and its severity. This paper tries to put these issues in a clearer perspective. The first part examines the origins of the shortfall by noting the extent to which pensions have lost value due to the recent economic crisis. The second section discusses the appropriate rate of return to assume on pension fund assets. The third section puts projected pension fund shortfalls in perspective by projecting their size relative to future state income. This is followed by a brief conclusion.

TheImpactoftheEconomicCrisisonPensionFund Assets
It is important to recognize that the main contributor to the current funding problem facing public pension funds was the collapse of the housing bubble and the subsequent downturn in the economy and the stock market. The plunge in the stock market led to a sharp decline in the value of pension fund assets. Figure 1 below projects pension fund assets if pensions had continued to earn on average a 4.5 percent nominal rate of return in the period since the end of 2007. Under this assumption, state and local pension fund assets would have been $857 billion higher at the end of the third quarter of 2010. The economic fallout from the collapse of the housing bubble has also led to budget shortfalls in state and local governments across the country. One result of these shortfalls is that governments reduced payments in pension funds. In the period since the beginning of the recession, annual payments into state and local pension funds have averaged $6.9 billion less than withdrawals. By contrast, in the three years prior to the downturn, payments averaged $18.4 billion more than withdrawals.1 If state and local governments had continued to contribute to their pensions at the same rate as they had in the prior three years, then the total assets of these funds would be $77 billion higher than was reported at the end of the third quarter of 2010. Adding this to the $857 billion figure above results in an additional $934 billion in pension funds, a figure far higher than most estimates of the size of state and local government shortfalls.

1 The data for these calculations are taken from the Federal Reserve Board, Flow of Funds, Table F.119, Line 3.

CEPR

The Origins and Severity of the Public Pension Crisis

FIGURE 1 Change in Public Pension Assets Since the Recession

4.0

3.5 trillions of dollars

With Risk-free Rate of Return (4.5%)

3.0

Actual 2.5

2.0 2007 2008 2009 2010:Q3

While state and local government pensions should be funded at levels that allow them to weather the impact of cyclical downturns, it is important to recognize that the current downturn is by far the longest and deepest of the post-war period. The managers of these funds obviously failed to recognize the housing bubble and the dangers it posed to the economy, but this was true of the vast majority of economic and business analysts at the time. Certainly state and local pension funds were not well served by the professional managers who advised them. It might be reasonable to ask why financial experts, who were often highly compensated for their services, failed to see such an obvious threat to the economy and the stock market as the collapse of a housing bubble.2 However, this is an issue of the failings of the financial industry, not the failings of state and local governments, except insofar as they exercised poor judgment in buying the industrys services. It is also worth noting that at the end of 2007 the start of the recession the stock market was not hugely out of line with its long-term trends. It had already fallen 5.4 percent from its value at the end of the third quarter and it was down by more than 10 percent from the peaks hit at the end of the first quarter of 2000, seven and a half years earlier. The price-to-earnings (PE) ratio for the market as a whole was 14.5 roughly even with its long-term average.3 In short, it might have been reasonable to expect some market turbulence at the end of 2007, given the impending collapse of the housing bubble, but market valuations were no longer at the extraordinary levels of the stock bubble years.
2 It was easy to recognize the housing bubble and the potential dangers it posed to the economy and the stock market (see Baker, 2002 and Baker, 2007). 3 These calculations are taken from the Federal Reserve Boards Flow of Funds, Table L.213, Line 19. The price-toearnings ratio uses after tax corporate earnings based on all corporate profits, including foreign earnings (Table 1.7.5, Line 17), minus taxes (Table 1.14, Line 12).

CEPR

The Origins and Severity of the Public Pension Crisis

ProjectingFuturePensionReturns
There has been a recent effort to argue that public pension funds should assume only the risk-free Treasury bond rate of return (Novy-Marx and Rauh, 2009). The nature of the argument is that a state or local government is no better situated to deal with risk than an individual investor. Such an argument is problematic for obvious reasons. An individual investor (or family) is unlikely to have diverse sources of income that can sustain him/her through difficult periods. A serious illness or prolonged period of unemployment is likely to cause the loss of most of an individual investors income. If the market is down at a point when a sharp loss of income necessitates relying on savings, then an individual investor will suffer considerably as a result of taking on risk. By contrast, it is difficult to envision plausible events that could lead state and local governments to experience comparable declines in income. Even the sharp downturn in revenue that followed in the wake of the collapse of the housing bubble led to declines in government revenue of less than 10 percent even in the most hard hit states. Individual investors must also be concerned about market fluctuations since they only retire once. Much of the savings of individual investors are focused on retirement. If the market is depressed at the point where they choose to or are forced to retire, then they could have a substantially lower income over the rest of their lifetimes than if they managed to retire when the market was on an upswing. However, state and local governments dont generally invest with an endpoint in mind. In principle, state and local governments will exist into perpetuity, so a period in which the market is depressed need not be of great consequence. Nonetheless, it is important that returns assumed by pension funds reflect the actual expected value for money invested in the stock market. This will depend in turn on the current price-to-earnings ratios in the stock market. Pension fund assumptions on stock returns were certainly not consistent with plausible assumptions on the growth of corporate profits and share prices during the 90s stock bubble. Many pension funds assumed that stocks would provide their historic rate of return even when PEs were in the high 20s or even 30s. For stocks to provide their historic rates of return at such high PEs, it would be necessary for PEs to rise even higher, hitting levels of well over 100 to 1 before the middle of the century (see Baker 1997; Diamond, 2000; Baker, Krugman, DeLong, 2005; and Weller and Baker, 2005). The correct long-term assumption on stock returns must be derived from dividend yields and the projected growth rate of corporate profits. This is a simple exercise. The current PE is approximately 13.1.4 In the first three quarters of 2010, firms paid out $728.4 billion in dividends, roughly 61.0 percent of the after-tax corporate profits.5 This is very close to the average share of
4 This is based on the $15.7 trillion market value of domestic corporations at the end of the 3rd quarter of 2010 (Flow of Funds Table, L.213, Line 23) divided by corporate profits minus taxes for the first three quarters $1,194.2 billion (NIPA Table 1.12 line 42 minus line 44). 5 Net stock purchases should be added to dividend payments since share buybacks are effectively an alternative way for firms to transfer earnings to their shareholders. In 2010, net share purchases were -$7.6 billion (Flow of Funds, Table F.4, Line 12).

CEPR

The Origins and Severity of the Public Pension Crisis

corporate profits paid out as dividends over the last two decades, which means that 2010 was not atypical. This implies a dividend yield of 4.0 percent. Corporate profit growth tracks GDP growth reasonably well over the long-term. This means that the projected returns would simply be the sum of the dividend yield, plus net share buybacks, and the average growth rate of GDP over the period in question. This is shown for the next 30 years in Table 1 below. The first column shows the projected capitalization of the U.S. market assuming that stock prices rise on average in step with corporate profits (i.e. the PE ratio remains constant) and that corporate profits increase at the same rate as the economy. The second column shows the annual dividend yields plus share buybacks, under the assumption that after-tax profits rise in step with GDP growth and the share of profits paid back to shareholders remains fixed. The third column shows the total return on stocks. This is the sum of the dividend and the capital gain. Over the period from 2011 to 2041, the average capital gain is projected to be 4.4 percent based on the Congressional Budget Offices (CBO) projection for the nominal growth rate in the economy. This gives an average nominal return of 8.4 percent from stock holdings. The fourth column projects the nominal return for the pension portfolio as a whole. The calculations assume that two-thirds of pension assets are held in equities or assets that might be expected to give a comparable return, such as hedge funds. It assumes that the other third is invested in long-term Treasury bonds (National Association of State Retirement Administrators 2010, Figure J). It projects an average interest rate of 5.0 percent for 30-year Treasury bonds (roughly a half percentage point higher than the current rate), following CBOs projection that interest rates will rise back to more normal levels in the next few years. These assumptions imply an average return of 7.3 percent. While this is somewhat lower than the 8.0 percent return that is commonly assumed by pension funds, it is worth noting that the inflation assumption in this calculation is considerably lower than what most pension funds use in their projections. Most pension funds assume an inflation rate of between 2.5 to 3.0 percent, compared to the 2.0 percent inflation assumption in this analysis. This means that the slightly lower assumption on returns would be offset by the lower assumption on costs due to a lower rate of inflation.

CEPR

The Origins and Severity of the Public Pension Crisis

TABLE 1 Projected Stock and Pension Fund Returns, 2011-2041 Market Dividend Stock Pension Fund Capitalization Payout Return Return (billions of $) (billions of $) (percent) (percent) 2011 16,156.1 643.7 19.0 14.4 2012 17,060.8 679.7 9.6 8.1 2013 18,016.2 717.8 9.6 8.1 2014 19,025.1 758.0 9.6 8.1 2015 20,090.5 800.4 9.6 8.1 2016 20,994.6 836.4 8.5 7.3 2017 21,939.4 874.1 8.5 7.3 2018 22,926.6 913.4 8.5 7.3 2019 23,958.3 954.5 8.5 7.3 2020 25,036.5 997.4 8.5 7.3 2021 26,088.0 1039.3 8.2 7.1 2022 27,183.7 1083.0 8.2 7.1 2023 28,325.4 1128.5 8.2 7.1 2024 29,515.1 1175.9 8.2 7.1 2025 30,754.7 1225.3 8.2 7.1 2026 32,046.4 1276.7 8.2 7.1 2027 33,392.4 1330.3 8.2 7.1 2028 34,794.8 1386.2 8.2 7.1 2029 36,256.2 1444.4 8.2 7.1 2030 37,779.0 1505.1 8.2 7.1 2031 39,365.7 1568.3 8.2 7.1 2032 41,019.1 1634.2 8.2 7.1 2033 42,741.9 1702.8 8.2 7.1 2034 44,537.0 1774.3 8.2 7.1 2035 46,407.6 1848.9 8.2 7.1 2036 48,356.7 1926.5 8.2 7.1 2037 50,387.7 2007.4 8.2 7.1 2038 52,504.0 2091.7 8.2 7.1 2039 54,709.1 2179.6 8.2 7.1 2040 57,006.9 2271.1 8.2 7.1 2041 59,401.2 2366.5 8.2 7.1 Average 2012-2041 8.4 7.3 Source: Federal Reserve Board and Bureau of Economic Analysis.

Pension funds can reasonably assume the returns projected in the table for the portion of their assets held in equity. Lower returns would require one or more of the three following assumptions: 1) Economic growth will be substantially lower than the Congressional Budget Office and other forecasters predict; 2) The profit share of output will experience a sustained fall over the next three decade; and/or 3) There will be a sustained decline in PE ratios.

CEPR

The Origins and Severity of the Public Pension Crisis

Any of these three assumptions would be an extraordinarily strong assertion about the future course of the economy and financial markets. While any or all of these projections for the future are possible, there should at least be an argument as to why one or more of these assumptions is likely. To date, those advocating that public pensions assume a lower rate of return on equity have not given an argument as to why their view of the future of the economy and financial markets differs from the consensus. In short, they are asking pension funds to depart from the economic consensus without providing either a theoretical argument or evidence to support their differing view of the future. To see that this projected path of returns is more plausible than assuming the risk-free rate, it is worth considering the implication for future PE ratios, if stock returns over the next 30 years are only equal to the risk-free rate. The calculations assume that the overall economy follows the same projected growth path.6 If the returns on stock are just equal to the returns on Treasury bonds, then the PE ratio will have to continually decline. This is necessary because the dividend yield is already almost as high as the yield on Treasury bills. This means that the price can only rise a very small amount, much less than the growth rate of profits, in order to keep the return equal to that on government bonds. As the PE falls, the dividend yield rises (firms are still paying the same share of their profits as dividends), which means that the PE must fall more rapidly. Figure 2 shows the PE ratios over the next two decades on the assumption that the yield on stocks is the same as the yield on Treasury bonds. As can be seen, this assumption would yield the absurd result that stock prices would have to turn negative. In short, unless there is an economic collapse, there is not a plausible story where stock returns over any long period will be equal or less than the Treasury bond rate.

6 It is of course possible that the economy will perform markedly worse than most projections assume, in which case low returns in the stock market may not be as implausible. However, there have been few sharp turns in growth paths in the post-war period (there was a slowdown in growth from the mid-70s to the mid-90s and a speed up since the year 1995), so it seems reasonable to plan as though a sharp turn is not a likely event. Furthermore if growth fell far enough below its projected pace, then even government bonds may not prove to be risk-free, since the federal government may find it too costly to meet its debt obligations and consider a partial restructuring.

CEPR

The Origins and Severity of the Public Pension Crisis

FIGURE 2 Projected Price-to-Earnings Ratios (Risk-free Rate of Return)

15

10

0 2010:Q3

2015

2020

2025

2030

Source: Federal Reserve Board, Bureau of Economic Analysis, and authors calculations.

It is also worth noting that if we look back historically at the years in which the PE ratio was below 15 to 1, then the real return has averaged well over 7.0 percent. Table 1A shows the return on stocks for the 30 years subsequent to a year in which the PE ratio was under 15 to 1. The average real return for the 18 years between 1949 and 1980 in which the PE ratio was below this level was 8.2 percent. The lowest return was 4.8 percent.7 It could be the case that governments would simply move away from holding stock as an asset for their pension funds if the assumed returns for assessing pension fund adequacy was the same as for government bonds. However, if governments went this route, it would mean that, on average, their pension funds would actually have worse returns, since the expected return on holding equity will in almost all circumstances be higher than the expected return from holding government debt.

7 The PE ratio is taken from the Economic Report of the President, 2010, Table B-95. The capital gain is taken as the rise in the S&P 500, deflated with the GDP deflator. The dividend yield is assumed to be the yield in the first year. The capital gain assumption probably understates slightly the gain from a full mix of stocks since it excludes newer fastgrowing companies. The dividend yield assumption may overstate slightly the return, because re-invested dividends may get a somewhat lower yield if stock prices have risen. On the other hand, a fund that is regularly rebalanced would not invest in stocks if their price rose at a pace that exceeded the rate of growth of the economy.

CEPR

The Origins and Severity of the Public Pension Crisis

TABLE 1A Historic Stock Returns, 30-year Averages (percent) Dividend Yield Real Appreciation Total Return 1949 6.6 2.7 9.3 1950 6.6 2.3 8.9 1951 6.1 1.8 7.9 1952 5.8 1.1 6.9 1953 5.8 2.0 7.8 1954 5.0 1.3 6.3 1955 4.1 0.7 4.8 1956 4.1 1.1 5.2 1957 4.4 1.9 6.3 1970 3.8 5.3 9.1 1973 3.1 3.3 6.4 1974 4.5 5.0 9.5 1975 4.3 5.3 9.6 1976 3.8 5.1 8.8 1977 4.6 5.7 10.4 1978 5.3 5.3 10.6 1979 5.5 4.4 9.9 1980 5.3 5.2 10.5 Average 4.9 3.3 8.2

There are two main consequences from a decision by public pension funds to forego ownership of equity. The first would be higher taxes and/or lower benefits, since the same level of benefits for workers would require more financing from the government. Higher returns from investments are a direct tradeoff with additional financing from the government. If actual returns drop as a result of holding government bonds in place of equities, then governments will have to pay more money to support the same level of benefits. Alternatively, governments can cut pension benefits for their workers, but even a lower level of benefits could be financed at lower cost to governments if pension funds were invested in equities. The other effect of pulling state and local pensions out of equities should be a somewhat higher rate of return on these assets. If a substantial pool of money, like state and local pension funds, were withdrawn from equity markets, it would mean that the remaining investors would get higher returns. Pension fund investment in stock markets can be seen as a way in which taxpayers share in the high yield available to equity investors. If pension funds are effectively excluded from equity markets, then it would leave a larger funding burden for the taxpaying public, while providing a higher return for those remaining in equity markets. The latter group is primarily wealthy investors. In effect, the result of forcing pension funds to divest themselves of equities would be a redistribution of income from the taxpaying public as a whole to wealthy investors.

CEPR

The Origins and Severity of the Public Pension Crisis

10

TheSizeofthePublicPensionShortfallinContext
There have been numerous media accounts in recent months warning of large shortfalls in public pension funds. Conventional estimates have placed the shortfall at around $1 trillion, while some analyses have put the shortfall as high as $3.2 trillion using a discount rate that implies pension funds will only earn the risk-free rate of return (Novy-Marx and Rauh, 2009). While there are important measurement issues in determining the size of the shortfall, it is also important that the number be placed in some context. Most people, including those involved in policy debates, will not have a good basis for assessing the meaning of a shortfall measured in the trillions of dollars that must be filled over an indefinite period in the future. The relevant context is the size of the projected shortfalls relative to the size of the state economies.8 Before going through this exercise, it is worth noting that the size of the shortfall in many of these funds has likely already been reduced as a result of the fact that the stock market has continued to recover from its downturn in 2008 and 2009. On July 1, 2010, the S&P 500 was already more than 11 percent higher than its July 1, 2009 level (from 987 on July 1, 2009 to 1101 on July 1, 2010). Most funds use the stock markets closing value at the end of the fiscal year as the basis for determining the valuation of their assets. Of course they also use an average, so the valuation would not simply reflect the market value at the end of the fiscal year. However, with the market having already risen substantially from its low (the S&P 500 had risen another 19 percent to 1293 by January 10, 2011), it is likely that pension valuations based on current and future market levels will show smaller shortfalls. In other words, a substantial portion of the shortfalls that were reported based on 2009 valuations have likely already been eliminated by the rise in the market. Table 2 shows funding levels and liabilities for most of the major state pension funds. The data are taken from the National Association of State Retirement Administrators (2010, Appendix B). The cumulative shortfall in funding as calculated in the table is $647 billion. Column 5 shows this shortfall expressed as a share of discounted future state output over the next 30 years, the assumption being that this would be roughly the period over which the shortfall needs to be closed. The calculations use a 3.0 percent real discount rate and assume that each state grows at the same rate as the overall economy.9

8 It is also reasonable to compare the size of the pension fund shortfalls to state budgets over the relevant time frame (see Lav and McNichol, 2011 and Munnell et al 2010) 9 Novy-Marx and Rauh (2009) perform similar calculations and come up with somewhat larger numbers. Their analysis is based on 2008 estimates of underfunding. It is also possible that this analysis includes a more complete set of state pension funds.

CEPR

The Origins and Severity of the Public Pension Crisis

11

TABLE 2 Funding Levels and Liabilities for Major State Pension Funds Actuarial Actuarial Value Funding of Assets Ratio (thousand $) State Plan (percent) AL Alabama Teachers 74.7 20,582,348 AL Alabama ERS 72.2 9,928,104 AK Alaska PERS 78.8 7,210,772 AK Alaska Teachers 70.2 3,670,086 AR Arkansas Teachers 75.7 10,617,000 AR Arkansas PERS 78.0 5,413,000 AZ Arizona SRS 79.0 27,094,000 AZ Arizona Public Safety PRS 70.0 5,445,497 CA California PERF 86.9 233,272,000 CA California Teachers 78.2 145,142,000 CO Colorado School 69.2 21,054,910 CO Colorado State 67.0 13,382,736 CO Colorado Municipal 76.2 2,932,628 CO Colorado Affiliated Local 89.2 1,855,493 CO Colorado Fire & Police 101.0 856,090 CT Connecticut Teachers 70.0 15,271,000 CT Connecticut SERS 51.9 9,990,200 DC DC Police & Fire 100.7 3,048,400 DC DC Teachers 92.2 1,445,000 DE Delaware State Employees 98.8 6,744,050 FL Florida RS 87.1 118,764,692 GA Georgia Teachers 91.9 54,354,284 GA Georgia ERS 85.7 13,613,606 HI Hawaii ERS 68.8 11,380,961 IA Iowa PERS 81.2 21,123,980 ID Idaho PERS 73.7 8,646,000 IL Illinois Teachers 52.1 38,026,044 IL Illinois Municipal 83.2 22,754,804

Unfunded Unfunded Liability as a percent of Future Liabilities Accrued Liability (thousand $) State Income (thousand $) 27,537,400 6,955,052 0.14% 13,756,176 3,828,072 0.08% 9,154,282 1,943,510 0.15% 5,231,654 1,561,568 0.12% 14,019,000 3,402,000 0.12% 6,938,000 1,525,000 0.05% 34,290,000 7,196,000 0.10% 7,778,394 2,332,897 0.03% 268,324,000 35,052,000 0.06% 185,683,000 40,541,000 0.07% 30,412,815 9,357,905 0.13% 19,977,217 6,594,481 0.09% 3,850,821 918,193 0.01% 2,081,304 225,811 0.00% 847,821 -8,269 0.00% 21,801,000 6,530,000 0.10% 19,243,400 9,253,200 0.14% 3,027,900 -20,500 0.00% 1,567,500 122,500 0.00% 6,827,006 82,956 0.00% 136,375,597 17,610,905 0.08% 59,133,777 4,779,493 0.04% 15,878,022 2,264,416 0.02% 16,549,069 5,168,108 0.27% 26,018,594 4,894,614 0.12% 11,732,200 3,086,200 0.20% 73,027,198 35,001,154 0.19% 27,345,113 4,590,309 0.03%

Latest Actuarial Valuation Date 9/30/2009 9/30/2009 6/30/2008 6/30/2008 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2008 6/30/2009 12/31/2009 12/31/2009 12/31/2009 1/1/2009 1/1/2009 6/30/2008 6/30/2008 10/1/2009 10/1/2009 6/30/2009 7/1/2009 6/30/2008 6/30/2009 6/30/2008 6/30/2009 7/1/2009 7/1/2009 12/31/2009

CEPR

The Origins and Severity of the Public Pension Crisis

12

TABLE 2 Funding Levels and Liabilities for Major State Pension Funds Actuarial Actuarial Value Funding of Assets Ratio (thousand $) State Plan (percent) IL Illinois Universities 54.3 14,282,000 IL Illinois SERS 43.5 10,999,954 IN Indiana PERF 97.5 9,293,952 IN Indiana Teachers 48.2 9,034,048 KS Kansas PERS 58.8 11,827,619 KY Kentucky Teachers 63.6 14,885,981 KY Kentucky County 70.6 7,402,277 KY Kentucky ERS 46.7 5,297,114 LA Louisiana Teachers 59.1 13,500,766 LA Louisiana SERS 60.8 8,499,662 MA Massachusetts Teachers 63.0 21,262,462 MA Massachusetts SERS 76.5 19,019,062 MD Maryland Teachers 66.0 20,600,000 MD Maryland PERS 63.8 11,800,000 ME Maine State and Teacher 74.0 8,631,558 ME Maine Local 112.7 2,201,653 MI Michigan Public Schools 83.6 45,677,000 MI Michigan SERS 82.8 11,403,000 MI Michigan Municipal 75.0 6,245,500 MN Minnesota Teachers 77.4 17,882,408 MN Minnesota PERF 70.0 13,158,490 MN Minnesota State Employees 85.9 9,030,401 MO Missouri Teachers 79.9 28,826,075 MO Missouri State Employees 83.0 7,876,079 MO Missouri Local 80.0 3,330,663 MO Missouri PEERS 80.7 2,792,182 MO Missouri DOT and Highway 47.3 1,471,497 MS Mississippi PERS 67.3 20,597,581 MT Montana PERS 83.5 4,002,212

Unfunded Unfunded Liability as a percent of Future Liabilities Accrued Liability (thousand $) State Income (thousand $) 26,316,200 12,034,200 0.07% 25,298,346 14,298,392 0.08% 9,034,573 -259,379 0.00% 18,750,063 9,716,015 0.13% 20,106,787 8,279,168 0.23% 23,400,426 8,514,445 0.19% 10,491,358 3,089,081 0.07% 11,332,961 6,035,847 0.13% 22,839,411 9,338,645 0.16% 13,986,847 5,487,185 0.09% 33,738,966 12,476,504 0.12% 24,862,421 5,843,359 0.06% 31,200,000 10,600,000 0.13% 18,500,000 6,700,000 0.08% 11,668,033 3,036,475 0.21% 1,953,629 -248,024 -0.02% 54,608,000 8,931,000 0.08% 13,766,000 2,363,000 0.02% 8,321,900 2,076,400 0.02% 23,114,802 5,232,394 0.07% 18,799,416 5,640,926 0.08% 10,512,760 1,482,359 0.02% 36,060,121 7,234,046 0.10% 9,494,807 1,618,728 0.02% 4,161,775 831,112 0.01% 3,458,044 665,862 0.01% 3,113,394 1,641,897 0.02% 30,594,546 9,996,965 0.36% 4,792,819 790,607 0.08%

Latest Actuarial Valuation Date 6/30/2009 6/30/2008 7/1/2008 6/30/2008 12/31/2008 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 1/1/2010 1/1/2010 6/30/2009 6/30/2009 6/30/2008 6/30/2008 9/30/2008 9/30/2008 12/31/2008 7/1/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 2/28/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009

CEPR

The Origins and Severity of the Public Pension Crisis

13

TABLE 2 Funding Levels and Liabilities for Major State Pension Funds Actuarial Actuarial Value Funding of Assets Ratio (thousand $) State Plan (percent) MT Montana Teachers 63.8 2,762,200 NC North Carolina Teachers and 99.3 55,127,658 NC North Carolina Local 99.6 17,100,739 ND North Dakota Teachers 77.7 1,900,300 ND North Dakota PERS 85.1 1,617,100 NE Nebraska Schools 86.6 7,007,582 NH New Hampshire Retirement 58.3 4,937,320 NJ New Jersey Teachers 65.0 34,708,001 NJ New Jersey PERS 64.9 28,879,176 NJ New Jersey Police & Fire 70.7 22,937,838 NM New Mexico PERF 84.2 12,575,142 NM New Mexico Teachers 67.5 9,366,300 NV Nevada Regular Employees 73.4 19,158,282 NV Nevada Police Officer and 68.9 4,813,594 NY NY State & Local ERS 107.3 128,916,000 NY New York State Teachers 106.6 88,254,700 NY NY State & Local Police & 108.0 22,767,000 OH Ohio PERS 75.3 55,315,148 OH Ohio Teachers 60.0 54,902,859 OH Ohio School Employees 82.0 9,723,000 OH Ohio Police & Fire 65.1 9,309,000 OK Oklahoma Teachers 49.8 9,439,000 OK Oklahoma PERS 66.8 6,208,245 OR Oregon PERS 80.2 43,520,600 PA Pennsylvania School 86.0 60,922,100 PA Pennsylvania State ERS 84.4 30,205,000 RI Rhode Island ERS 56.2 6,231,411 RI Rhode Island Municipal 90.3 1,064,615 SC South Carolina RS 69.3 24,699,678

Unfunded Unfunded Liability as a percent of Future Liabilities Accrued Liability (thousand $) State Income (thousand $) 4,331,000 1,568,800 0.15% 55,518,745 391,087 0.00% 17,173,975 73,236 0.00% 2,445,900 545,600 0.06% 1,901,200 284,100 0.03% 8,092,339 1,084,757 0.04% 8,475,052 3,537,732 0.21% 53,418,429 18,710,428 0.13% 44,470,403 15,591,227 0.11% 32,442,101 9,504,263 0.07% 14,932,624 2,357,482 0.11% 13,883,300 4,517,000 0.21% 26,087,621 6,929,339 0.19% 6,987,537 2,173,943 0.06% 120,183,000 -8,733,000 -0.03% 82,777,500 -5,477,200 -0.02% 21,072,000 -1,695,000 -0.01% 73,466,166 18,151,018 0.13% 91,440,955 36,538,096 0.27% 14,221,000 4,498,000 0.03% 14,307,000 4,998,000 0.04% 18,950,900 9,511,900 0.22% 9,291,458 3,083,213 0.07% 54,259,500 10,738,900 0.23% 70,845,600 9,923,500 0.06% 35,797,000 5,592,000 0.04% 11,083,014 4,851,603 0.35% 1,179,233 114,618 0.01% 35,663,419 10,963,741 0.24%

Latest Actuarial Valuation Date 7/1/2009 12/31/2008 12/31/2008 7/1/2009 6/30/2009 7/1/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2009 6/30/2008 4/1/2008 6/30/2008 4/1/2008 12/31/2008 6/30/2009 6/30/2009 1/1/2008 6/30/2009 7/1/2009 12/31/2008 6/30/2008 12/31/2009 6/30/2007 6/30/2007 7/1/2008

CEPR

The Origins and Severity of the Public Pension Crisis

14

TABLE 2 Funding Levels and Liabilities for Major State Pension Funds Actuarial Actuarial Value Funding of Assets Ratio (thousand $) State Plan (percent) SC South Carolina Police 77.9 3,363,136 SD South Dakota PERS 91.8 6,778,500 TN TN State and Teachers 96.2 26,214,995 TN TN Political Subdivisions 89.5 4,897,974 TX Texas Teachers 83.1 106,384,000 TX Texas ERS 87.4 23,509,622 TX Texas County & District 89.8 16,564,213 TX Texas Municipal 75.8 16,305,700 TX Texas LECOS 86.1 780,808 UT Utah Noncontributory 85.6 16,622,548 VA Virginia Retirement System 84.0 52,548,000 VT Vermont Teachers 65.4 1,374,079 VT Vermont State Employees 78.9 1,217,638 WA Washington PERS 2/3 101.1 16,692,700 WA Washington PERS 1 70.9 9,852,900 WA Washington Teachers Plan 1 76.8 8,262,300 WA Washington Teachers Plan 2/3 107.9 5,681,000 WA Washington LEOFF Plan 1 128.0 5,592,500 WA Washington LEOFF Plan 2 126.4 5,052,700 WA Washington School Employees 104.3 2,302,600 WI Wisconsin Retirement System 99.8 78,911,300 WV West Virginia PERS 79.7 3,930,701 WV West Virginia Teachers 41.3 3,554,771 WY Wyoming Public Employees 87.5 5,742,542 Total 79.8 $2,561,175,228

Unfunded Unfunded Liability as a percent of Future Liabilities Accrued Liability (thousand $) State Income (thousand $) 4,318,955 955,819 0.02% 7,387,400 608,900 0.06% 27,240,151 1,025,156 0.01% 5,475,620 577,646 0.01% 128,030,000 21,646,000 0.07% 26,907,779 3,398,157 0.01% 18,448,162 1,883,949 0.01% 21,525,100 5,219,400 0.02% 907,102 126,294 0.00% 19,429,734 2,807,186 0.09% 62,554,000 10,006,000 0.09% 2,101,838 727,759 0.10% 1,544,144 326,506 0.04% 16,508,000 -184,700 0.00% 13,901,000 4,048,100 0.04% 10,753,900 2,491,600 0.03% 5,263,800 -417,200 0.00% 4,367,700 -1,224,800 -0.01% 3,998,200 -1,054,500 -0.01% 2,207,300 -95,300 0.00% 79,104,600 193,300 0.00% 4,930,158 999,457 0.05% 8,607,869 5,053,098 0.28% 6,565,677 823,135 0.08% $3,208,469,565 $647,294,337

Latest Actuarial Valuation Date 7/1/2008 6/30/2008 7/1/2007 7/1/2007 8/31/2009 8/31/2009 12/31/2009 12/31/2009 8/31/2009 12/31/2009 6/30/2008 6/30/2009 6/30/2009 6/30/2008 6/30/2008 6/30/2008 6/30/2008 6/30/2008 6/30/2008 6/30/2008 12/31/2009 7/1/2009 6/30/2009 1/1/2010

CEPR

The Origins and Severity of the Public Pension Crisis

15

In most states the unfunded liabilities are well under 0.2 percent of future income. This implies that increased revenue equal to 20 cents of every $100 of future output would be more than sufficient to eliminate the shortfall. Even in the states with largest shortfalls, the burden appears manageable. In Ohio, the shortfall is equal to 0.47 percent of future output, in Illinois it is 0.37 percent of future output, and in Mississippi and Rhode Island it is equal to 0.36 percent. Of course, this estimate of the size of the shortfall will be overstated or understated if a state has growth that exceeds or falls behind the national average. Some of the states with larger shortfalls, like Ohio and Mississippi, may lag the overall growth of the economy, which means that the burden of the unfunded pension liability would be greater than the calculations in Table 2 imply. Of course, since the valuation date for the pension funds was before the recent run-up in the stock market, some portion of this shortfall will be eliminated simply by the recovery of the stock market when the valuation is updated.

Conclusion
The shortfalls facing most state and local pension funds have been seriously misrepresented in public debates. The major cause of these shortfalls has not been inadequate contributions by state governments, but rather the plunge in the stock market following the collapse of the housing bubble. Given the low PE ratios in the stock market, pension fund assumptions on the future rate of return on their assets are consistent with most projections of economic growth and past experience. Furthermore, when expressed relative to the size of their economies, most states are facing shortfalls that appear easily manageable.

CEPR

The Origins and Severity of the Public Pension Crisis

16

References
Baker, Dean. 1997. Saving Social Security With Stock: The Numbers Dont Add Up. New York: Century Foundation, available at http://tcf.org/publications/1997/2/pb400/?searchterm=%22dean%20baker%22. Baker, Dean. 2002. The Run-up in Home Prices: Is It Real or Is It Another Bubble? Washington, DC: Center for Economic and Policy Research, available at http://www.cepr.net/documents/publications/housing_2002_08.pdf. Baker, Dean. 2007. Midsummer Meltdown: Prospects for the Stock and Housing Markets. Washington, DC: Center for Economic and Policy Research, available at http://www.cepr.net/documents/publications/DB_Midsummer%20Meltdown%20Final.pdf Baker, Dean, Brad DeLong, and Paul Krugman. 2005. Asset Returns and Economic Growth. Brookings Papers on Economic Activity, No. 1: pp. 289-315. Board of Governors of the Federal Reserve System. 2003. Flow of Funds Accounts for the United States, March. Washington, D.C.: Board of Governors of the Federal Reserve System. Diamond, Peter A. 2000. What Stock Market Returns to Expect for the Future? Social Security Bulletin, Vol. 63, No. 2: pp. 38-45, available at http://www.ssa.gov/policy/docs/ssb/v63n2/v63n2p38.pdf Lav, Iris, and Elizabeth McNichol, 2011. Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm, Washington, DC: Center on Budget and Policy Priorities http://www.cbpp.org/cms/index.cfm?fa=view&id=3372 Munnell, Alicia, H. Jean-Pierre Aubry, and Laura Quinby, Public Pension Funding in Practice, NBER Working Paper 16442, October 2010. National Association of State Retirement Administrators. 2010. Public Fund Survey: Summary of Findings for Fiscal 2009. Baton Rouge, LA: National Association of State Retirement Administrators. Novy-Marx, Robert and Joshua Rauh. 2009. The Liabilities and Risks of State Sponsored Pensions. Journal of Economic Perspectives, Vol. 23, No. 4: pp. 191-210. Weller, Christian and Dean Baker. 2005. Smoothing the Waves of the Perfect Storm: Changes in Pension Funding Rules Could Reduce Cyclical Underfunding. Labor and Employment Relations Series, Proceedings of the 57th Annual Meeting, available at http://www.press.uillinois.edu/journals/lera/proceedings2005/weller1.html.